New Unrelated Business Taxable Income Liability for Providing Certain Fringe Benefits

In this Ropes & Gray podcast, tax partner Kendi Ozmon and tax counsel Gil Ghatan discuss one of the key provisions for tax-exempt organizations from the Tax Cuts and Jobs Act (TCJA) – the new unrelated business taxable income (UBTI) rules for certain fringe benefits. As of January 1, section 512(a)(7) now treats certain employee fringe benefit expenses as giving rise to UBTI for tax-exempt employers, including expenses related to providing transportation-related benefits. This Ropes & Gray podcast explains new section 512(a)(7), provides examples of how it works in the real world and explores the necessity for future guidance as tax-exempt employers consider estimated tax payments.

For additional information related to the TCJA’s effect on tax-exempt organizations, please click here.

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Transcript:

Speaker: Hello, and thank you for joining us today on this Ropes & Gray podcast. I’m joined by Kendi Ozmon and Gil Ghatan, who focus their practices on representing tax-exempt organizations. In today’s podcast, we are going to discuss an important change to the Unrelated Business Income Tax (also referred to as “UBIT”), enacted as part of the Tax Cuts and Jobs Act (the “TCJA”) that may not yet be on everyone’s radar screens. Kendi, why don’t we jump in with a little background here?

Kendi Ozmon: So we’re talking about new section 512(a)(7), which is already in effect. It was effective as of January 1 of this year, and it treats the costs incurred by tax-exempt employers with respect to certain fringe benefits as creating unrelated business taxable income (“UBTI”). Let me repeat that point because it is a counterintuitive one: this provision treats expenses as income for a tax-exempt employer. Let’s break down the components of this new Code section. It tells us that UBTI will be increased by costs incurred by a tax-exempt employer that:

1. Would have been non-deductible under section 274 if the employer were taxable; and
2. Are paid or incurred for any of three specific types of employee benefits.

The three types of employee benefits are

1. Qualified transportation fringe benefits;
2. Parking facilities used in connection with qualified parking; and
3. On-premises athletic facilities.

So, there are two conditions here. First, the expense must be one that would have been non-deductible under section 274, which is the general rule barring a deduction for taxable employers with respect to certain entertainment expenses. Second, the expense must be one that fits within one of these three fringe benefit categories. With respect to that first condition, it’s important to understand that the TCJA also changed section 274. The version of section 274 that was in the House version of the Act would have specifically disallowed deductions for taxable employers for their expenses associated with providing the exact same three categories of fringe benefits enumerated in section 512(a)(7). The idea here is that Congress was trying to put employers, taxable and tax-exempt, in the same economic position: denying a deduction for taxable employers for their expenses associated with providing certain employee fringe benefits and, because tax-exempt employers don’t really care about losing deductions (they are tax-exempt after all), the way to replicate this lack of deduction for a tax-exempt employer is to impose a tax on them based on the amount of the expense incurred for providing that same set of benefits to their employees.

There’s a wrinkle here, though, because in the final version of the TCJA, the section 274 Amendment and the new section 512(a)(7) don’t match up exactly. The version of section 274 that was enacted only specifically refers to denying an employer deduction for expenses associated with qualified transportation fringe benefits. There’s no specific reference to parking facilities, and no mention of on-premises athletic facilities, which remained in section 512(a)(7) although they were dropped from the final section 274 amendments. So that leaves one to wonder how to interpret section 512(a)(7). Treasury has, at least informally, acknowledged that the reference to on-premises athletic facilities in section 512(a)(7) is currently inoperative since a deduction for these facility expenses is not currently denied under section 274. The treatment of parking facility expenses remains unclear, and we’ll talk a bit about that later.

Speaker: So just off the bat it’s clear that this is a new type of provision we’re not used to seeing under the UBIT rules.

Kendi Ozmon: That’s right. The UBIT rules were designed to impose a tax on exempt organizations with respect to their net income from operating trades or business unrelated to their tax-exempt purposes. The basic idea being, if you’re operating a business comparable to a taxable organization, you should pay tax on the net income from that business. Section 512(a)(7) departs from that regime and instead says that an employer’s expenses from providing certain fringe benefits to its employees are treated as UBTI – expenses create income. And unlike other UBIT provisions, this means there isn’t the ability to offset the tax with expenses from the activity; in fact, it’s the expenses themselves that give rise to the income.

Speaker: It sounds like there is a lot of uncertainty with this new section and how it will actually work in certain situations. Why don’t we start with some of the clearer cut scenarios? Gil?

Gil Ghatan: Well the clearest scenario involves a qualified transportation fringe benefit that the employer provides to its employees by paying a third-party. Now let’s put aside for the moment pre-tax elections and just consider benefits the employer provides in excess of an employee’s compensation. Kendi mentioned the term “qualified transportation fringe” earlier. What does that mean under current law? A qualified transportation fringe (or a “QTF” for short) includes three categories of transportation benefits:

1. Transportation in a commuter highway vehicle – these are the commuter buses and vanpools that employees take back and forth to work from home;
2. Transit passes; and
3. Qualified parking – this is parking the employer provides on or near the business premises.

I should note, by the way, that the TCJA did not change the ability of an employee to exclude qualified transportation fringe benefits from income (except for bicycle commuting reimbursements, which is a fourth category of QTF, and because these amounts are now taxable to employees they would not give rise to UBTI under 512(a)(7)). But for the other types of QTFs, even though taxable employers can’t deduct these expenses, and tax-exempt employers have UBTI as a result of incurring them, employees still can exclude these benefits from income, up to certain limits.

So let’s consider the simplest cases – employer pays for an employee transit pass or parking at a third-party parking facility. Assume the cost of the passes and parking are within the income exclusion limit (currently $260/month), the employer would have UBTI up to the exclusion amount. If the expense of the employer exceeds the exclusion limit, the employee would have taxable income for the excess but the employer’s UBTI would be capped at the exclusion limit. It’s not entirely clear whether you get there by saying that the excess is not a QTF or whether you rely on language in section 274 that says a deduction is permitted if the amount is includible in the employee’s taxable income. Since the excess is includible in the employee’s income, a taxable employer could claim a deduction, meaning a tax-exempt employer should not have UBTI. Either way, the UBTI would seem to have an upper limit for these types of QTFs that the employer funds by making a payment to a third-party.

Speaker: Kendi, Gil mentioned these transportation fringe benefits can be paid for with pre-tax employee contributions. There’s been some confusion about whether pre-tax employee contributions create UBTI for tax-exempt employers. What’s the issue here and do we have any clarity on this yet?

Kendi Ozmon: So, Section 512(a)(7) refers to amounts “paid or incurred” by the exempt organization and section 274(a)(4) refers to expenses of the employer. As part of their employee benefit programs, many employers permit employees to elect to have some of their wages taken out of their paychecks and use that amount to purchase transit passes, pay for parking, or contribute to a commuting reimbursement account. As you noted, there has been some debate about whether pre-tax programs would constitute amounts paid or incurred by the organization such that they would give rise to UBTI. The basic analysis is that the employer is effectively reducing the amount of compensation being paid to the employee and is instead using those funds to provide the employee with a QTF benefit.

In fact, the IRS recently updated Publication 15-B, which is the Employer’s Tax Guide to Fringe Benefits. That publication included a new “Tip” that makes clear that the deduction disallowance under section 274 applies to expenses for qualified transportation fringe benefits through a “compensation reduction agreement” – that’s the technical term for a pre-tax election program. So the IRS, at least, has come out stating that pre-tax employee contributions would be treated as an employer expense under section 274, which by extension means a pre-tax employee contribution would also be treated as an expense that gives rise to UBTI under section 512(a)(7).

Speaker: Employee pre-tax transportation programs are extremely popular and widespread among all types of employers, including exempt organizations. It seems that this is likely to create a tax liability for a large number of employers, many of whom many not be prepared for it, or able to afford it.

Kendi Ozmon: That’s exactly right. While it’s too early to say what employers are likely to do, we’re certainly aware of some employers that are considering terminating their pre-tax election programs. This would mean employees would now bear the cost of the transportation benefit using after-tax dollars, effectively shifting the tax burden from employers to their employees.

Speaker: So let’s complicate things, or maybe I should say complicate things further. How about parking? You mentioned this earlier, but there seems to be a lot of uncertainty about the explicit reference to parking facilities in section 512(a)(7) and the absence of such a reference in section 274. What are you seeing and hearing on this?

Gil Ghatan: This is probably the most confusing aspect. Just to restate it, to be taxable as UBTI under 512(a)(7), the expense must be one that is disallowed under 274. So this means that in order for parking facility expenses to give rise to UBTI under 512(a)(7) (a section that specifically refers to parking facilities), one must first conclude that taxable employers are denied a deduction for parking facility expenses under section 274(a)(4) (a section that does not refer to parking facilities and just refers to qualified transportation fringes).

As we already noted, there’s an apparent mismatch between the language used in 512(a)(7) and that used in 274, and this can be traced back to changes made between the House version of the TCJA and what became the final version. The House version included a specific reference to parking facilities in both 274 and 512 – just like it did for on-premises athletic facilities – whereas the final version retained the House language for 512 but went with the Senate’s version of 274, which did not include a reference to parking facilities or on-campus athletic facilities. So one is left to speculate as to whether the removal of the parking facility reference under 274 reflects an intentional policy decision not to pick up parking facilities.

Remember, sections 512(a)(7) and 274 serve to impose a tax liability on employers in connection with the foregone tax on employees that results from the transportation fringe being excluded from the employee’s taxable income. However, both of these sections are written in terms of an employer’s expenses – a taxable employer is denied a deduction for expenses associated with qualified transportation fringes and an exempt employer has UBTI. For many types of transportation fringes – notably, transit passes and parking at third-party facilities – the amount excluded from the employee’s income equals the amount of the expense incurred by the employer. But that’s not the case when we’re talking about the employer’s own facility expenses. To determine the value of employer-provided parking for purposes of an employee’s income exclusion, one looks to the fair market rental value of the parking spot. However, the fair rental value may depart significantly from the employer’s expense of providing the parking. The employer’s expenses may include maintenance, overhead, security, insurance, personnel costs and likely even depreciation.

Speaker: Right. So the parking facility expenses could greatly exceeds the rental value.

Gil Ghatan: Exactly. Take, for example, an employer that has lots of parking available and so offers that parking to everyone, employees and the general public, at no charge. Under the technical reading of the Code and regulations, as well as an IRS notice from 1994, the employer has provided its employees a QTF, albeit one with a value of $0. In the past, it was not very important to determine whether a QTF was provided or not – either way, the employee had no amount included in income. But now, because of 512(a)(7) and the possibility that parking facility expenses could be taxed as UBTI, even for a $0 benefit, this becomes very important. If that employer has provided its employees with a QTF, then even though the value of the benefit received by the employees is $0, the employer would need to include as UBTI its expenses of providing that parking. This seems like it can’t have possibly been the intent but that’s potentially where we end up if Treasury concludes that parking facility expenses are covered by this new provision. So that’s one big issue with concluding that parking facility expenses are picked up.

Speaker: That would seem to be enough but are there more?

Gil Ghatan: Well the other big one is the issue of double counting or essentially imposing UBTI for multiple reasons connected with employer provided qualified parking. Take, for example, an employer that has a garage and charges employees fair rental value for that lot. And to keep things simple, let’s assume that the fair rental value is less than the employee income exclusion amount of $260 per month. But assume that the employees pay for that parking using a pre-tax election. As Kendi mentioned earlier, the IRS has gone on record that it will treat a pre-tax election as if the employer paid or incurred the cost, so the employer would have UBTI to the extent of the pre-tax election by the employees. But now, if parking facility costs are picked up, that means this employer not only has UBTI to the extent of the pre-tax election for parking, but also potentially has UBTI with respect to all of its expenses associated with that garage. That seems like double counting and likely also could not have been the intent here.

Speaker: Well it seems like guidance will be needed to resolve these issues related to parking facility expenses.

Kendi Ozmon:  Definitely. Unfortunately, we all know that the IRS and Treasury are working with limited resources and there is a pressing need for guidance with respect to many aspects of tax reform legislation. Treasury and the IRS updated their joint Priority Guidance Plan recently to add two items from the TCJA to the list of exempt organization items they intend to address with some form of guidance before the end of June. These are the new UBTI basketing or siloing rule that requires exempt organizations to calculate UBTI separately for each trade or business and the new excise tax on executive compensation. Guidance on the provision we’ve been discussing, section 512(a)(7), didn’t make the cut. But we know that Treasury is interested in hearing about issues with other provisions, even if they didn’t make the Priority Guidance Plan, and we think there is a need for immediate guidance on some of the parking facility expense issues Gil outlined, particularly since organizations need to start thinking about estimated tax payments for their UBTI – hard to do when a significant potential tax liability remains so uncertain.

Speaker: Well thank you Kendi and Gil for joining me in the trenches on this topic. I suspect there’s a lot more we could get into and that we’ve only scratched the surface on the issues that exempt organizations are going to be wrestling with as they seek to navigate these new rules. Please stay tuned for future podcasts from Ropes & Gray’s tax-exempt group and, of course, if we can help you to maneuver through any of these challenges, please don’t hesitate to get in touch. Thank you for joining us.